Real Estate Economists Staying Positive but Reining in Optimism

After predicting an uptick in U.S. economic growth and interest rates six months ago, real estate economists have tempered their forecasts, moving closer to the predictions of one year ago. While the April 2017 optimism could be attributed to proposals to reform the tax code, reduce regulatory burdens, and invest in infrastructure, little progress has been made on tax reform and infrastructure and the economy seems to be back to business as usual after the global financial crisis. As a result, real estate economists now have lower expectations about economic growth, employment growth, and interest rates than they had in the spring. Key real estate metrics, such as NCREIF Property Index (NPI) returns and transaction volumes, which showed little change six months ago, have moved slightly lower in this survey. While expectations have moderated, forecasters predict that the current expansion is poised to set an all-time longevity record and real estate will clearly benefit.

These results are based on the semiannual ULI Real Estate Economic Forecast (formerly ULI Consensus Forecast), prepared by the ULI Center for Capital Markets and Real Estate. The survey was completed by 46 economists/analysts at 35 leading real estate organizations in September and early October 2017.

Some highlights from the survey, which covers the 2017–2019 forecast period, include the following:

U.S. gross domestic product (GDP) will grow by 2.2 percent in 2017 and 2.4 percent in 2018—declines of 10 and 20 basis points (bps), respectively, since the last forecast (April 2017). Forecasts for both years are close to the 20-year average of 2.35 percent, with growth moderating to 2.0 percent in 2019.

Net job growth should average 1.76 million per year through 2019, compared with a long-term average of 1.2 million. Compared with the last economic forecast, expected job growth is down in all years. Job growth is forecast at 2.0 million in 2017, falling to 1.5 million in 2019, possibly due to concerns about labor availability, as the unemployment rate drops to 4.2 percent in 2018, the lowest rate since 2000.

Expected yields on the ten-year U.S. Treasury note fell in the most recent forecast, after rising in the prior survey. Consistent with lower GDP growth expectations, the forecast year end (YE) yield dropped 40 bps to 2.4 percent for 2017, 50 bps to 2.7 percent in 2018, and 20 bps to 3.0 percent in 2019. Yields are expected to remain well below the 20-year average of 3.8 percent.

Real estate transaction volumes will fall to $450 billion in 2017, a decline of $46 billion (9 percent) from the 2016 level. The 2017 forecast is unchanged from the last two editions. Transaction volume forecasts for 2018 and 2019 are lower than they previously were, at $427 billion and $414 billion, respectively. Real Capital Analytics reports that U.S. transactions are down about 12 percent year-to-date (YTD) as of July, but brokers expect a strong fourth quarter and $450 billion should be achievable.

Expectations for commercial mortgage–backed securities (CMBS) issuance were stable. The consensus is for $80 billion in new CMBS issuance in all three forecast years (2017–2019), a slight uptick from $76 billion in 2016 and very close to the 20-year average of $78 billion. It seems clear that the record issuance of $229 billion in 2007 is out of reach for the foreseeable future.

Commercial real estate prices as measured by the RCA Commercial Property Price Index (CPPI) are projected to rise by an average of 4.0 percent per year over the next three years (5.0 percent, 4.1 percent, and 3.0 percent, respectively), compared with the prior forecast’s average of 3.9 percent and the long-term average increase of 5.6 percent. As of July, the CPPI is up 4.6 percent YTD, so the 2017 forecast could be on the conservative side.

Rent growth expectations for the next three years was higher for hotels (revenue per available room [RevPAR]) and apartments compared with the last forecast and was lower for other property types. Industrial rent growth will lead all property types with 2017–2019 growth averaging 3.7 percent, followed by hotels (2.7 percent RevPAR growth), apartments (2.3 percent), office (2.0 percent), and retail (1.7 percent). Compared with the last forecast, retail rents fell the most (60 bps), likely a response to elevated levels of retailer bankruptcies and announced store closings.

Over the next three years, national vacancy or availability rates are forecast to rise modestly for all property types except industrial, which will stay flat. Apartment vacancy will increase from 4.8 percent at YE 2016 to 5.1 percent in 2019, down from 5.4 percent in the prior survey. Industrial availability will be 7.9 percent in 2019—no change from 2016, and well below the long-term average of 10.2 percent. The office vacancy rate will increase by 40 bps over the next three years, ending 2019 at 13.4 percent. Finally, retail availability will finish 2019 with 10.3 percent vacancy, a 20-basis-point increase over 2016.

Forecast returns as measured by the NCREIF Property Index (NPI), which tracks core unleveraged institutional properties, have moderated compared with the prior update. Total returns are forecast at 6.6 percent, 6.0 percent, and 5.8 percent for 2017, 2018, and 2019, respectively. Much of the forecast return will come from income, which is forecast at 5.0 percent in 2017 and rising to 5.3 percent in 2019. As was the case for the past year, industrial should be the strongest property type, with an average total return of 8.7 percent through 2019, compared with 6.1 percent for the overall index. All other property types will trail the index, with average returns of 5.6 percent (apartments) and 5.5 percent (office and retail).

Expectations about equity real estate investment trust (REIT) returns are lower compared with the spring forecast. The NAREIT composite is forecast to average 6.2 percent from 2017 to 2019, about 1 percent lower than the prior forecast and well below the 20-year average of 11.6 percent. Expected returns are very similar to private returns, as measured by the NPI.

The single-family housing outlook improved over the past six months, with starts forecast to reach 960,000 units in 2019, closing in on the long-term average of 1.0 million per year. Home price growth is forecast to average 4.8 percent over the next three years, 80 bps more than the prior forecast.

While the results of the ULI Real Estate Economic Forecast discussed above are based on the median of responses, there were interesting outlier forecasts, particularly on the downside. Most notably, not everyone is convinced that the expansion will continue into 2019—the low estimate for GDP and job growth in that year are 0 percent and –1.7 million, respectively. Consistent with this view, the minimum forecast U.S. Treasury yield in 2019 was 1.6 percent. NPI returns for 2019 range from a high of 9 percent to a low of -5 percent, with industrial having an even wider spread.

In summary, respondents to the October 2017 ULI Real Estate Economic Forecast have downplayed the possibility of a spike in economic growth through 2019. At the same time, they have confirmed that the current expansion could become the longest one since records began being kept in the 19th century. While real estate will benefit from continued growth, the U.S. property markets are close to equilibrium, which should result in inflationary rent growth and returns in the single digits for core real estate and equity REITs.

Interest rates have been on a roller-coaster ride over the last year, but cap rates are largely unchanged. The result of these moves is that cap rate spreads relative to the safe investments in the 10-year U.S. Treasury bonds have moved back to the levels seen in 2017. Given everything that has changed over the last year—as well as everything that has not—there may be room for cap rate spreads to move lower.

At the 2019 ULI U.K. National Conference, a panel on the practicalities of real estate investment reflected on the opportunities and challenges, not least in terms of the impact that Brexit is having on investor sentiment, as well as where we are in the market cycle. Multifamily continues to do well, while retail is struggling as in overbuilt markets.